AI Stocks Took a Breather in Q3 After a Blistering Q2 Rally

Key Takeaways

• Investors reallocated between AI stocks in the third quarter. Former high-flying hardware stocks lost steam, while hyperscalers and software advanced.
• Shares of hyperscalers Microsoft and Meta rose as their AI businesses appeared to gain momentum.
• Software stocks rebounded from their first-half losses.

The years-long rally in artificial intelligence stocks stalled in the third quarter. The Morningstar Global Next Generation Artificial Intelligence Index ended the quarter up just 6%, representing a slowdown from the second quarter’s 42% gain. Year to date, the group is still up 36%. Under the hood, there was a rotation among the AI stocks investors favored.

The AI Index, whose largest holdings include Nvidia NVDA and Microsoft MSFT, was held up in the quarter by the tech giants making big investments in the AI infrastructure buildout, plus software stocks that came back into favor and are no longer considered “AI losers.” Meanwhile, many hardware stocks that staged huge rallies earlier in the year lost ground, and gains were uneven among semiconductor names.

Outside the tech sector, second-order beneficiaries of the data center buildout, like construction equipment makers and power generator suppliers, pulled back from their second-quarter rally.

“A lot of people are looking for where the puck is going,” says Sameer Samana, senior strategist at Wells Fargo Investment Institute. “People are starting to notice it’s possible what might be more valuable going forward is how AI enters people’s lives.” He says data and user bases are key assets in that pursuit.

In the year’s first half, the AI trade was all about data center buildouts and hardware: semiconductors, data storage devices, bulldozers. SanDisk SNDK, Micron MU, and Intel INTC each more than tripled in value. Data center construction fueled sales growth in once staid businesses, driving shares of Caterpillar CAT, GE Vernova GEV, and Corning GLW sharply higher.

Those market darlings fell victim to a stock rotation in the third quarter. AI spenders took over leadership from the beneficiaries of their spending, and software stocks that slumped through the first half caught a bid from investors reconsidering AI’s disruptive capacity. Outside the tech sector, second-order beneficiaries of the data center buildout, like construction equipment makers and power generator suppliers, pulled back from their second-quarter rally.

Hyperscalers Kept the AI Trade Afloat in Q3

Hyperscalers—the tech giants whose massive data-center spending underpins the AI trade—picked up the slack from semiconductors. The combination of momentum in their AI businesses and the possibility of a spending slowdown helped bolster sentiment toward names that had been treading water.

In the quarter, shares of Microsoft rose 38%, while Meta Platforms META rose 29%, together adding nearly 4 points to AI index returns. Early in the quarter, investors had qualms about their businesses. Microsoft shares were hammered by concerns that AI-enabled coding would upend the software industry, while Meta was pressured by uncertainty about its ability to monetize AI without a cloud computing business.

Then, Microsoft shares skyrocketed in late July after executives reported another quarter of accelerating cloud growth and assured investors that despite anticipating higher capital expenditures, the company would remain free-cash-flow-positive in its 2027 fiscal year. Investors have been alarmed by hyperscalers’ dwindling free cash flows as they plow money into data centers. Meta stock had its best day in over a year in late September, when its Muse AI agent overtook ChatGPT as the most popular free app in the Apple App Store.

Hyperscalers got another boost in September, when top AI executives advocated an industrywide slowdown in frontier model development to address growing safety concerns. Bank of America analysts noted that the slowdown could give hyperscalers “more time to build competitive proprietary models and capture more of the AI value chain.” Slower model development could also ease some of the financial pressure of soaring capital expenditures.

Software Stocks Rebounded

Throughout the end of 2025 and the first half of 2026, software stocks were dogged by concerns that increasingly capable AI coding agents would disrupt the industry’s high-margin business model. But things began to look up in the third quarter, when the Morningstar US Software Application Index rose 18%, while the Morningstar US Software Infrastructure Index advanced 32%. As a group, software stocks accounted for more than half of the Next Gen AI Index’s return last quarter, according to Morningstar Direct’s equity attribution data.

Software companies have also posted stronger-than-expected earnings in recent quarters, helping to assuage fears about AI-driven disruption. “Despite some worries about a massive shift toward AI spending and away from software spending, the demand environment remains stable,” wrote Eric Compton, director of technology research at Morningstar Equity Research, in a recent report.

Some analysts expect software companies to continue benefiting as AI matures. Thomas Christopher, communications services and tech equity analyst at Wells Fargo Investment Institute, estimates that declining token prices—usage-based pricing for large-language models—will help drive adoption. “As foundation models become more accessible, durable competitive advantages may increasingly come from data, workflow ownership, enterprise relationships, and the ability to deliver measurable business outcomes,” favoring software incumbents.

Chip and Memory Rally Hit the Skids

In the third quarter, formerly high-flying chip and memory stocks succumbed to gravity after a stunning second quarter, when they accounted for a whopping 37.5 percentage points (90%) of the AI Index’s total return. Memory suppliers Western Digital WDC and SK Hynix SKHY each declined more than 20% in the quarter, and together with Micron erased 1.12 points from the index’s return.

Two-thirds of the AI Index’s chip stocks finished the quarter in the red, but the industry was net positive for the index, thanks to a few industry giants. Nvidia, Advanced Micro Devices AMD, and Taiwan Semiconductor Manufacturing TSM, which together account for nearly 20% of the index, rose in the quarter, adding 1.78 points to the index’s return.

Wells Fargo’s Samana says the pullback in hardware stocks has created “a little bit of an opportunity” for investors. “It’s hard to see how, if the AI trade continues, hardware doesn’t do well.”